Warren Buffett's partner, Charlie Munger, once said, "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
For corporate boards, using bad incentives for management's pay can be disastrous (think Lehman Brothers). Incentives based on singular metrics such as revenue growth, EBITDA, ROE, or earning per share are easily manipulated and gamed. Fortunately, there is a better way, EVA Momentum.
Created by Bennett Stewart of EVA Dimensions, co-creator of EVA (Economic Value Added), Stewart says EVA Momentum is "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
For explanations of either term, click here for EVA and here for EVA Momentum.
So what does this mean for investors? The best companies are those creating value above their cost of capital, as reflected by a positive EVA momentum. The higher the EVA momentum, the stronger management's value creation.
Let's look at Cisco and two of its networking & communication devices industry peers to see how effectively they create value. Here are the EVA momentum figures for each company over several time periods.
|Cisco (Nasdaq: CSCO )
|Hewlett-Packard (NYSE: HPQ )
|Juniper (Nasdaq: JNPR )
Source: Capital IQ, a division of Standard & Poor's, and author's calculations.
Of these three high-tech companies, Hewlett-Packard's management has been creating the most value. It is questionable whether this will continue as the company's former CEO, Mark Hurd, left the company after a small scandal. Meanwhile, both Cisco and Juniper have not been making more than their cost of capital, also known as destroying shareholder value.
Businesses with high EVA momentum are effectively creating value. With such a new metric, it will be interesting to see how useful it proves to companies and investors. If it lives up to its promise, it will be an essential tool in investors' tool belts.
One more tool
Most investors don't keep tabs on their companies' cash flow, and that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home run stocks that provide the market's best returns.
We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.